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Calculating WACC, NPV, IRR & PV of depreciation tax shields

A1. (Calculating the WACC) The following values apply to the Drop Corporation: rd = 7.5%, re = 13%, T = 38%, D = $100, and E = $200. What is the weighted average cost of capital?

A2. (Mutually exclusive projects) Consider the cash flows given below for the mutually exclusive projects, S and L.
a. If the cost of capital is 10%, what is the NPV of each investment?
b. What is the IRR of each investment?
c. Which investment should you accept?
YEAR 0 1 2
Project S 100 160 0
Project L 100 0 200

A3. (MACRS depreciation) Modigliani Jet Ski Company has purchased several firm cars for a total of $150,000. They are classed as five-year property.
a. What is the annual depreciation charge for these assets?
b. If Modigliani's marginal tax rate is 40%, what is the annual depreciation tax shield?
c. Discounted at 8%, what is the present value of the depreciation tax shields?

Solution Preview

Please refer attached file for better clarity of formulas in MS Excel.

A1
Cost of debt=rd=7.50%
Cost of equity=re=13%
Tax Rate=T=38%
Debt=D=$100
Equity=E=$200

Weight of Debt=wd=D/(D+E)=0.3333
Weight of Equity=we=E/(D+E)=0.6667

WACC=wd*rd*(1-T)+we*re=10.22%

A2
a. If the cost of capital is 10%, what is the NPV of each investment?

Project S
Year Cash Flow PV
n Cn Cn/(1+10%)^n
0 -100 -100.00
1 160 145.45
2 0 0.00
NPV $45.45

Project L
Year Cash Flow PV
n Cn Cn/(1+10%)^n
0 -100 -100.00
1 0 0.00
2 200 165.29
NPV ...

Solution Summary

There are 3 problems. Solution to first problem depicts the steps to calculate WACC. Solution to second problem calculates the NPV and IRR values for each of the given projects and choose the best one. Solution to third problem describes the steps to estimate the PV of depreciation tax shields in the given case.

$2.19